An article on the tax problems when a company carries on two or more trades and the shareholders contemplate the sale of only certain of them by David Hughes, a tax consultant with Moore Stephens, London
Published in the January 2001 issue of "Tax Adviser"
The fact that a company carries on two or more trades may pose significant tax problems when that company's shareholders, being individuals, contemplate the sale of only certain of those trade(s). In this regard the demerger reliefs contained in sections ICTA 1988, ss. 213 - 218 would be precluded by virtue of section 213(11)(d) i.e., the intended disposal of a trade to a third party. In these circumstances the shareholders are potentially faced with a double tax charge, the first being on the disposal of the target trade by the company, and the second being on the extraction of the net sale proceeds from that company. This article examines Insolvency Act, s.110 reconstructions from a capital gains tax perspective, a route often used to avoid the double charge to tax that may arise in these circumstances.
The example below illustrates the nature of this problem.
Mr Taunton owns the entire share capital of Taunton Orchards Ltd. The company carries on two trades; 1) the growing and selling of apples, 2) the design and maintenance of web sites. Mr Taunton has just received an offer of £5,000,000 for the ‘web’ trade. The prospective purchaser has however made it clear that he has no interest whatsoever in purchasing the company's orchard business.
If Taunton Orchards Ltd simply disposes of the web business and pays the net of tax proceeds as a dividend to Mr Taunton the following liabilities will crystallise.
Taunton Orchards Ltd
Corporation tax computation
Sale of web business 5,000,000
Cost (assumed negligible) (0)
Capital gain 5,000,000
Tax at 30% (1,500,000)
Net Proceeds £3,500,000
Income tax computation
Tax @ 25% (875,000)
Net Receipt £2,625,000
Taunton Orchards Ltd 1,500,000
Mr Taunton 875,000
Mr Taunton's advisers recommend the following strategy to avoid the double charge to tax.
- The formation of two new companies Taunton Apples Ltd and Taunton Web Ltd.
· The appointment of a liquidator for Taunton Orchards Ltd.
· The transfer during the course of the liquidation of Taunton Orchards Ltd :
· of the orchard business to Taunton Apples Ltd in consideration of that company issuing shares to Mr Taunton; and
· of the Web business to Taunton Web Ltd, in consideration of that company issuing shares to Mr Taunton.
Thus after the reconstruction instead of holding Taunton Orchards Ltd Mr Taunton would hold the share capital of Taunton Apples Ltd and Taunton Web Ltd.
Mr Taunton would then sell Taunton Web Ltd for £5,000,000.
Capital gains tax computation (Ignoring annual exemption)
Sale proceeds 5,000,000
Capital gain 5,000,000
Taper relief 25% (1,250,000)
Net gain £3,750,000
Tax @ 40% £1,500,000
Net Receipt = £5,000,000 - £1,500,000 = £3,500,000.
Mr Taunton’s after tax receipt would now be £3,500,000, which compares very favourably with the net receipt of £2,625,000 which he would have been entitled to had the restructuring not been carried out. It should be noted that the tax savings involved will be even more dramatic once higher rates of business asset taper relief kick in.
In order for the proposed reconstruction outlined above to achieve the desired tax outcome the following disposals must be relieved from a charge to tax:
· The transfer of the trades to Taunton Apples Ltd and Taunton Web Ltd. (Taunton Orchards Ltd) TCGA 1992, s. 139.
· Disposal of the shares in Taunton Orchards Ltd. (Mr Taunton) TCGA 1992, s.136.
Sections 136 and 139 are now considered in some detail below.
TCGA 1992, s. 136
Section 136 provides that
‘a) Where an arrangement between a company and the persons holding shares in or debentures of the company, or any class of such shares or debentures, is entered into for the purposes of or in connection with a scheme of reconstruction or amalgamation, and
b) under the arrangement another company issues shares or debentures to those persons in respect of and in proportion to (or as nearly as may be in proportion to) their holdings of shares in or debentures of the first-mentioned company, but the shares in or debentures of the first-mentioned company are either retained by those persons or cancelled
then those persons shall be treated as exchanging the first-mentioned shares or debentures for those held by them in consequence of the arrangement ...’
Section 136 then provides for the application of s. 135 ‘Exchange of securities for those in another company’ to the transaction. Where the conditions in s. 135 are satisfied section 135 applies ss. 127 -131. In particular, s. 127 equates the original shares and the new holding so that the reconstruction will ‘not be treated as involving any disposal of the original shares or any acquisition of the new holding… but the original shares… and the new holding… shall be treated as the same asset acquired as the original shares were acquired.’
For the relief in s. 136 to apply, the conditions in s. 137(1) must be met - i.e. the reconstruction or amalgamation must be effected for bona fide commercial reasons and not form part of a scheme or arrangement of which the main purpose, or one of the main purposes is avoidance of liability to capital gains tax or corporation tax.
Under s. 138 it is possible to obtain notice in advance that the Board of the Inland Revenue are satisfied that the reconstruction or amalgamation will be effected for bona fide commercial reasons and will not form part of a scheme or arrangements of which the main purpose or one of the main purposes is avoidance of liability to capital gains tax or corporation tax.
To obtain clearance under s. 138, application in writing must be made setting out the particulars of the operations to be effected. The Board then must reply within 30 days either setting out their decision or requesting further information. If the Board request further information the applicant has 30 days to comply.
If the Board refuse to grant clearance or fail to notify their decision within 30 days, the applicant may within 30 days of the notification or of that time require the Board to transmit the application etc. to the Special Commissioners who will then determine the issue.
It should be noted that s. 138(5) provides that if any particulars furnished do not fully and accurately disclose all facts and considerations material for the decision of the Board or the Special Commissioners any clearance previously granted is thereby void.
Section 139 provides relief in respect of the transfer of a business during a reconstruction or amalgamation.
Section 139(1) requires:
· the transfer of whole or part of a company's business to another company;
· that both the transferor and transferee companies are resident in the United Kingdom; and
· that the transferor company receives no consideration for the transfer other than the transferee company taking over the whole or part of the liabilities of the business.
For disposals taking place after 31 March 2000 the requirement to be UK resident has been relaxed so that s. 139 applies also where the assets being transferred are chargeable assets in relation to the transferee immediately after the transfer and are chargeable assets of the transferor immediately before the transfer (FA 2000, s. 102, sch. 29, para. 5).
Where the above conditions are satisfied the transfer is treated as taking place at no gain no loss and the transferee company is treated as having acquired the assets at the transferor's acquisition date.
Section 139(5) requires that the reconstruction or amalgamation is effected for bona fide commercial reasons and does not form part of a scheme or arrangements of which the main purpose or one of the main purposes is avoidance of liability to corporation tax, capital gains tax or income tax.
The acquiring company can apply to the Board of the Inland Revenue for clearance in advance using the procedure set out in s. 138 (see above).
It is important to underline that s. 139 requires the transfer of the whole or part of the business and would not apply where individual assets were disposed of which did not constitute the whole or part of a business. The Revenue interpret this provision to require the transfer of an ‘identifiable part’ of the business. In SP 5/85 the Revenue state that ‘In the context of demergers and the legislation contained in TA 1988, ss. 213-218 a shareholding in a company which is a 75 per cent subsidiary of the distributing company is regarded as constituting an identifiable part of the trade or business of the distributing company.’
ICTA 1988, s. 703
As well as the capital gains tax clearances described above, it will be necessary to apply for clearance under TA 1988, s. 707, that the proposed transactions do not fall within s. 703 ‘Cancellation of tax advantages from certain transactions in securities.’
Section 703(1) provides that ... ‘[where] a person is in a position to obtain, or has obtained, a tax advantage, then unless he shows that the transaction or transactions were carried out either for bona fide commercial reasons ... and that none of them had as their main object, or one of their main objects, to enable tax advantages to be obtained, this section shall apply to him in respect of that transaction or those transactions.’
Taunton Orchards Ltd: Likely outcome
Provided clearances are applied for it is likely that the reliefs contained in ss. 136 and 139 will apply to the reconstruction of Taunton Orchards Ltd. Furthermore it is unlikely that the transaction will be treated as falling foul of s. 703. Therefore Mr Taunton should be successful in his attempt to avoid the double charge to tax that would otherwise have arisen if the reconstruction had not taken place.
The example set out above confined itself to a relatively straightforward fact pattern. Additional considerations that often arise in practice are:
Mitigation of potential TCGA 1992, s. 179 charges
Where assets have been transferred intra group within six years prior to the transferee company leaving the group during the course of the reconstruction s. 179 potentially applies to crystallise a gain. In certain circumstances it is possible to mitigate these charges by, for example:
- re-associating the transferor and transferee companies so that they leave the group together;
· transferring the asset previously transferred back to the transferor company prior to the transferee company leaving the group.
The interposition of a new holding company to act as a liquidation vehicle
The liquidation of a company carrying on trades poses many practical problems (e.g. vis-à-vis creditors, employees, etc.). For this reason it may be appropriate to consider establishing a new holding company, which would then be liquidated. (Further consideration of this topic is outside the scope of this article.)
The form of the consideration for the disposal of the target company
Where the consideration for the disposal of the target company is in the form of shares or securities it may be possible, subject to the detailed provisions contained in TCGA 1992, sch. A1, to extend the period of ownership qualifying for business asset taper relief. Where this is achievable, the tax payable in respect of the disposal may be deferred and its amount reduced.
It is important to note that the form of consideration receivable in respect of the disposal of the target company may affect the outcome of the clearance applications.
Without the existence of various reliefs considerable exposure to stamp duty would flow from the transactions comprising the reconstruction. It is therefore important to ensure that the proposed reconstruction satisfies the various conditions necessary to obtain the relevant stamp duty reliefs.
The impact of VAT on the reconstruction must not be overlooked.
Where, as in the example being considered, a trade is being transferred as a going concern the transfer, provided it falls within VATA 1994, s. 49 and para. 5 VAT (Special Provisions) Order 1995, should not be chargeable to VAT. However, where throughout the reconstruction the trade undergoes a number of consecutive transfers, the transfer of a going concern relief may not apply and it is prudent to obtain a ruling from Customs in such circumstances.
In conclusion, by utilising the available reliefs it should be possible to mitigate the potential double charge to tax arising on the disposal of certain of a company's trades where the shareholders being individuals wish the disposal proceeds to be distributed to them. A clearance procedure is available which should provide some comfort. Nevertheless it is important not to overlook various pitfalls, e.g. s. 179 charges, stamp duty and VAT.
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January 2001 by